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Substantial Decline Required in Value of Dollar

February 26, 2003

Contact:

C. Fred Bergsten

(202) 328-9000

John Williamson

(202) 328-9000

Washington, DCFurther substantial declines in the foreign exchange value of the dollar will be needed in order to make a serious dent in the record US current account deficit of almost $500 billion (about 5 percent of GDP) in 2002. To this end, the US administration should abandon all traces of its prior "strong dollar" rhetoric. In addition, Japan and China (and perhaps a few other countries) should cease excessive currency interventions, which have retarded the needed correction of the dollar. These are the central conclusions of Dollar Overvaluation and the World Economy, a new report published today by the Institute for International Economics.

The main topics discussed in the volume are:

How much of a reduction in the external deficit should policy aim at achieving?

How large a decline in the foreign exchange value of the dollar would be needed to achieve that reduction?

Which currencies should strengthen as the counterpart to a further weakening of the dollar?

What would be the implications for the US and world economies of such a currency realignment?

A majority of participants in the Institute's conference on this topic last September, whose papers make up most of the new volume, took the view that a sensible target for the current account would be a significantly smaller deficit than now prevails or is likely to prevail on existing trends. Some argued for aiming to roughly halve the deficit, to around 2.5 percent of GDP. Others argued that the superior US productivity performance of recent years raises the rate of return on capital in the United States, which makes a larger capital inflow profitable and can finance a larger current account deficit of 3 or even 4 percent of GDP. But a wide variety of views supported a substantial reduction in the deficit: concerns about a double-dip recession fostered by further sharp increases in the trade deficit, about the long-term structural impact on the manufacturing sector, about an excessive buildup of US net indebtedness to the rest of the world, about the danger of an eventual dollar crash and hard landing, and about the danger of fomenting trade protectionism.

Most conference participants endorsed the view that a further substantial correction of the exchange value of the dollar would be needed to achieve an improvement in the external balance of the United States. The dollar has fallen somewhat since the conference (see the attached table) but nothing like the 25 percent from the peak value of the dollar that some conference participants believed to be needed (compared with the rise of 35 to 40 percent from 1995 to early 2002 and an actual decline of 5 to 10 percent to now, depending on which index is used). However, there were also those who argued that a much smaller decline of the dollar would suffice (because a larger current account deficit can be financed for the foreseeable future) and those who argued that it would be better not to have too sharp a decline in the short run because that would require cutting back demand in the United States.

One of the most interesting views expressed at the conference was that any renewed dollar depreciation should not have its counterpart only in appreciation of the yen and euro, as has been traditional, but that a much broader range of currencies will need to participate. These include the Chinese renminbi, the Canadian dollar, and several of the smaller Asian currencies. Conversely, a number of participants argued that Japan's economic difficulties make appreciation of the yen's effective exchange rate impossible, or at least counterproductive.

However, there was also widespread agreement that Japan should not be intervening in the exchange markets to weaken, or even to stop the strengthening of, the yen, as it has done extensively in the recent past. In addition, particular importance was attached to ending the sizable purchases of dollars by the Chinese authorities that keep the renminbi at an undervalued level. There was widespread agreement that any remnant of the "strong dollar" policy of the US administration should be jettisoned because even rhetorical comments in that direction may retard the needed correction.

The consequences of renewed dollar depreciation would be positive for output and employment in the United States, especially in the manufacturing sector, although there would inevitably be some increase in inflationary pressure. Matters are more complicated in the rest of the world, but it was argued by many participants that the shock of currency appreciation might help to jolt the countries involved into much-needed policy changes. This was viewed as particularly likely to have positive results in Europe, where appreciation of the euro could be expected to reduce European inflation and thus motivate the European Central Bank into an overdue cut in interest rates (and perhaps also jog European governments into deeper structural reforms).

About the Editors

C. Fred Bergsten has been director of the Institute for International Economics since its creation in 1981. He was assistant secretary for international affairs of the US Treasury (1977-81), assistant for international economic affairs to the National Security Council (1969-71), and a senior fellow at the Brookings Institution (1972-76), the Carnegie Endowment for International Peace (1981), and the Council on Foreign Relations (1967-68). He is the author, coauthor, or editor of 30 books on a wide range of international economic issues, including No More Bashing: Building a New Japan-United States Economic Relationship (2001), Global Economic Leadership and the Group of Seven (1996), The Dilemmas of the Dollar (2d ed., 1996), and America in the World Economy: A Strategy for the 1990s (1988).

John Williamson, senior fellow at the Institute for International Economics since 1981, was project director for the UN High-Level Panel on Financing for Development (the Zedillo Report) in 2001; on leave as chief economist for South Asia at the World Bank during 1996-99; economics professor at Pontificia Universidade Católica do Rio de Janeiro (1978-81), University of Warwick (1970-77), Massachusetts Institute of Technology (1967, 1980), University of York (1963-68), and Princeton University (1962-63); adviser to the International Monetary Fund (1972-74); and economic consultant to the UK Treasury (1968-70). He is author, coauthor, or editor of numerous studies on international monetary and developing world debt issues, including Delivering on Debt Relief: From IMF Gold to a New Aid Architecture (2002), Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option (2000), The Crawling Band as an Exchange Rate Regime (1996), What Role for Currency Boards? (1995), Estimating Equilibrium Exchange Rates (1994), and The Political Economy of Policy Reform (1993).

About the Institute

The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. Its staff of about 50 focus on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and cover all key regionsespecially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site.